Europe's Deficit Cutting Could Hurt the U.S. Economy

After Germany and Britain announced earlier this week that they're making substantial cuts to government spending in an effort to reduce budget deficits, alarm is growing in the U.S. that the austerity measures will torpedo the global recovery, including the fledgling expansion in America.

"This is getting ugly," economist Paul Krugman wrote on his New York Times blog. "The U.S. needs to be thinking about how to insulate itself from European masochism." And the Times' editorial board weighed in on the topic Thursday, saying that right now, for most of the big economies, "slashing budgets is the wrong thing to do."

German Chancellor Angela Merkel announced Tuesday that her government was slashing $96 billion in spending beginning next year, including plans to cut 15,000 civil service jobs. She said the measures were necessary because Germany faces "serious, difficult times."

At the same time, Britain's new government said it plans to cut government spending to avoid the kind of financial crisis now affecting Greece and Spain. "We must go about the urgent task of cutting our deficit in a way that is open and fair," said Prime Minister David Cameron.

U.S. Will Feel Europe's Squeeze

The U.S. concern is based on academic research that shows in a world of free exchange rates, budget cutting by one country is soon transmitted to other countries, leading to contraction elsewhere.

In a simplified way, it works like this: Germany cuts its deficit. It then needs to borrow fewer euros, which results in less demand for the European currency. Interest rates fall, investors then switch to investments denominated in other currencies. That makes the euro cheaper against the U.S. dollar, the greenback appreciates and that hurts U.S. exports.

Figures released Thursday by the U.S. government show that the trade deficit inched up to $40.3 billion in the first quarter, compared with $40 billion in the quarter earlier. But economists say it will take several more months before the effects of European austerity measures may be felt in the U.S. economy.

Bad Timing

Economists say Germany's rationale for cutting the budget now doesn't make much sense. In fact, U.S. Treasury Secretary Timothy Geithner had called on Sunday for "stronger domestic demand growth in Japan and the European surplus countries," which includes Germany.

"Germany is not suffering from a lack of confidence in the financial markets, and there's no reason why they should do fiscal retrenchment, especially at the moment where Europe and the world will need an increase in German domestic demand," says Domenico Lombardi, senior fellow at the Brookings Institution in Washington, D.C.

"This is going to have repercussions not just in Europe, but elsewhere in the global economy, including the U.S.," Lombardi warns.

It has been argued that because of financial market pressure, some European countries like Greece, Spain and Portugal need to reduce their deficits to regain investor confidence in their bonds. But the case is different in big surplus countries like Germany, where interest rates on government bonds have hit historic lows.

Insulation: Little Can Be Done

Lombardi says the austerity measures could affect the U.S. in a number of ways. The most significant is trade -- the U.S. sends one-fifth of its exports to Europe. If the continent is going to import less, that will hurt U.S. companies.

Currency competitiveness is also a problem. With the euro falling, American companies will struggle to make sales in other markets like Asia as well because European products will now be cheaper.

A third impact will be on U.S. financial institutions -- of the foreign assets they're exposed to, almost half is in Europe. If those assets plunge in value, that would hurt American banks.

Polina Vlasenko, a research analyst at the American Institute for Economic Research in Great Barrington, Mass., says the Obama Administration can do very little to insulate the U.S. from the effects of the European measures.

"I don't see any particularly implementable method by which the U.S. can isolate itself from the influences of other economies," she says. "The connections go through both financial markets and international trade, and shutting down either of those channels is not a good idea."

Vlasenko says it's an open question whether the same problems would have emerged if Europe had not decided to cut deficits. After all, she says, the euro was falling against the dollar because of financial market fears before the deficit cuts were announced. That would have probably produced the same changes in trade patterns anyway.